Chapter5:

ConsumptionandSaving
1
Outline
1. Introduction
2. Simple Dynamic Model
i. Closed Economy
ii. Open Economy
2
3. Analysis of Shocks
a. Transitory Shocks to GDP
b. News Shocks
c. Permanent Shocks to GDP
d. Real Interest Rate Shock
4. BorrowingConstraints
5. DeterminationofRealInterestRate
6. Summary
3
1. Introduction
So far we looked at how people make
decisions about their activities within time
(intratemporal decisions).
But most decisions have a time (dynamic)
aspect associated with them they are
intertemporal decisions.
Tomorrows consumption depends on how
much you consumed today.
4
We will analyze an important dynamic
decision: Consumption Saving decision.
Saving reduces consumption today
But it can increase consumption in the future
So the question is, what is the best way to
allocate consumption over time?
5
2. Simple Dynamic Model
For simplicity, assume that representative
household lives only for 2 time periods.
Also (for simplicity) assume that there is no
intratemporal decision.
Consumption today (c
1
) and consumption
tomorrow (c
2
) are treated as different
goods.
6
Just like we have preferences between leisure
and consumption, we have preferences between
c
1
and c
2
: Utility function, u(c
1
, c
2
).
7
Assume that:
1. Household is given some amount of
output exogenously in each period: (y
1
, y
2
)
(an endowment economy)
2. Output can not be stored.
3. "Robinson Crusoe" isolated island
(coconuts) with no links to outside world:
Closed economy.
8
i. Closed Economy
Household chooses (c
1
, c
2
) to maximize
u(c
1
, c
2
) subject to: c
1
y
1
and c
2
y
2
.
Trivial solution: Choose c
1
= y
1
and c
2
= y
2
.
Household consumes everything it is given
each period.
Economy must live within its means on a
periodtoperiod basis.
9
10
International Bond Market
Bond: Promise (by issuer) to deliver something of
value at a future date (to the bond holder).
Real world has mostly nominal bonds:
E.g., Student issuing a bond for $10,000 to the
bank, promises to redeem it after 1 year for
$11,000 ($10,000 is the principal payment and
$1,000 is nominal interest payment).
In such case, nominal interest rate on the bond is
10%.
11
ii. Open Economy
Our model has no money (only coconuts)
nominal bonds are useless.
But there can be something called a real
bond: Promise to deliver output (in form of
future consumption) at a later date.
This could be you borrowing a case of beer
from your roommate and repaying with a
case of beer next day (0% real interest rate),
or it could be CPIindexed government
bonds.
12
Lets say there is a world market in real
bonds, with gross real interest R = 1 + r.
Island is a small open economy.
Trading bonds means we can save and
borrow: We can save (or borrow) some of
todays output on the market in exchange
for a bond that promises output tomorrow
(or that requires that we repay some
output tomorrow).
13
Saving Currentincome Currentspending
OR
s y
1
c
1
(1)
Closed economy: s = 0.
Open economy: Country can be net lender
(s > 0) or net borrower (s < 0).
14
If a country lends (or borrows) s units
today, it expects to get (or pay back)
principal and interest tomorrow:
c
2
= y
2
+ Rs (2)
Combining equations (1) and (2), we get
intertemporal budget constraint (IBC):
c
2
= y
2
+ R(y
1
c
1
)
15
16
IntertemporalBudgetConstraint
Ability to borrow and lend from outside
world:
1. Greatly expands consumption opportunities.
2. Slope of the budget line (R) represents the
intertemporal price of consumption: An increase
in R makes c
1
more expensive and c
2
less
expensive (or increases the return on savings).
3. IBC still passes through the endowment point
(y
1
, y
2
).
17
We can rearrange IBC as:
Present value of consumption flow =
Present value of GDP flow (wealth).
With international financial market,
economy does not have to consume c
1
= y
1
,
c
2
= y
2
but anywhere along IBC.
c
1
> or < y
1
, c
2
> or < y
2
, and is limited by
its lifetime wealth.
18
You can not borrow any quantity you like,
only quantity you will be able to pay back
(maximumy
2
/R).
Recall incomeexpenditure identity:
Y C + I + G + X M
If G is in form of consumption on current
needs, then savings:
S Y C G I + TB.
19
SavingsandTradeBalance
With no investment in the model, this
implies that:
S = TB
Saving requires trade balance surplus,
borrowing requires trade balance deficit.
20
Mathematically, household again chooses
(c
1
, c
2
) to maximize its utility u(c
1
, c
2
) subject
to IBC: c
1
+ c
2
/R = y
1
+ y
2
/R.
At the optimal point A, two conditions are
satisfied:
1. Slope of indifference curve (= MRS(c
1
, c
2
))
equals slope of budget constraint (= R).
2. Point A lies on budget line.
21
Consumption SavingBehavior
22
In this figure, country runs a trade balance
surplus, and saves.
This depends on parameters: Here GDP in first
period is much larger than GDP in the second
period.
Households smooth their consumption
spending over time.
They save by buying bonds that allow them to
consume more in next period (they pay for
these by using some of y
1
).
23
3. Analysis of Shocks
Our theory shows how consumer demand
and saving depends on GDP, interest rates
and preferences:
(c
1
D
, c
2
D
, s
D
) = f (y
1
, y
2
, R, u).
24
Now we find responses of (c
1
D
, c
2
D
, s
D
)
after:
a. Transitory shocks to GDP.
b. Anticipated shocks to GDP (note that
consumer spending depends on future
GDP).
c. Permanent shocks to GDP.
25
We learned in Chapter 2 that productivity
shocks increase GDP.
Imagine there is a oneperiod shock to
productivity, so that Ay
1
> 0, Ay
2
= 0.
R does not change, because it is set on world
markets and the economy is small.
What happens in our model? What do people
do?
26
a. Transitory Shocks to GDP
What happens to the intertemporal budget
constraint?
Lets consider an economy without trade.
Production shifts from A to B (more y
1
).
Transitory increase in current GDP made
residents wealthier.
If c
1
and c
2
are normal goods, people will want
to consume more both today and tomorrow:
Ac
1
> 0, Ac
2
> 0) new indifference curve
tangent at C.
27
28
People can transfer some of todays extra y
1
abroad in exchange for a bond which redeems
next year for extra c
2
.
Mild and prolonged consumption boom.
Again this shows the consumptionsmoothing
behavior of households: Consumption goes up
in period 1 (by less than y
1
) and also in period 2.
29
Financial markets act as a shock absorber
to small open economy!
Households can absorb the GDP shock by
spreading it over time and keeping
consumption relatively stable.
30
New information about future, leading people to
change expectation about what will happen.
For example, surprise news about higher
productivity next period makes households
expect Ay
2
> 0 but does not affect this periods
output (Ay
1
= 0).
News just before the end of a recession.
News about new technological development that
will arrive soon.
31
b. News Shocks
How do households react to this
information?
What happens to the intertemporal budget
constraint?
32
Production shifts from A to B (expect more y
2
).
Current GDP does not change but shock makes
people wealthier.
If c
1
, c
2
are normal goods, people will consume
more both today and tomorrow (Ac
1
> 0, Ac
2
> 0) new indifference curve tangent at C.
Again, consumptionsmoothing motive is at
work.
33
34
Savings declines and trade balance moves
into deficit.
Households are wealthier because of
higher GDP next period.
International bond market allows them to
borrow some of tomorrows consumption
(Hence trade balance deficit: X M< 0).
35
We need to be careful about interpreting
trade balance deficits.
1. They can be result of bad output shocks.
2. They can be result of good news shocks.
36
In recessions, consumption spending improves before
GDP does.
Often, this can be interpreted as if the higher spending is
the reason for the end of recession.
According to our theory, the argument runs in reverse:
Increase in spending is caused by households
adjusting expectations about future GDP (laid off
workers may receive information that their former
employers will rehire in near future, and adjust their
spending).
The end of recession would arrive even if households
would not spend more.
37
Be very careful at interpreting correlations
in data as causality!
In econometrics, we call this reverse
causality (Christmas spending comes
before Christmas, but does not cause
Christmas to come).
38
c. Permanent Shocks to GDP
Now imagine that productivity rises
permanently, increasing GDP by the same
amount Ay
1
= Ay
2
= Ay > 0.
This is just a combination of the previous
two shocks.
The change can be depicted as the 45
0
line
shift of the endowment point (A B).
39
No change in R parallel shift in IBC.
Shock makes people wealthier, but by larger
amounts than before.
If consumption is normal good, then:
Ac
1
D
> 0 and Ac
2
D
> 0.
40
Consumption and GDP dont have to rise by
same amounts It depends on preferences of
people between today and tomorrow.
But for simplicity we look at case C where Ac
1
D
= Ay
1
and Ac
2
D
= Ay
2
.
Consumption increase is much larger than
before: Ac
1
D
/ Ay
1
= 1.
Response of consumption to productivity shocks
depends on whether they are temporary or
permanent.
41
42
d. Real Interest Rate Shock
Real interest rate, R, is a price you have to
pay to transfer consumption from
tomorrow into today. A space machine!
Well, actually it only works if there is
someone else wishing to do the opposite.
But we assume world bond market,
remember?
43
Recall that changes in prices have
substitution and wealth effects.
In terms of saving behavior:
For borrowers: These two effects work in
the same direction.
For lenders: These two effects work in
opposite direction.
44
In our model, lenders are likely to have
high current income and low future
income: y
1
> y
2
.
Example1: Individuals, who are in their
peak earning years, expecting to retire
soon.
Example2: A small open economy
currently experiencing a transitory boom in
GDP.
45
In our model, borrowers are likely to have
low current income and high future
income: y
1
< y
2
.
Example1: Young people with their peak
earnings approaching soon.
Example2: A small open economy
currently experiencing a transitory
recession.
46
If the interest rate, R, rises, the current
consumption becomes more expensive than
future consumption.
The substitution effect implies that people
would want to substitute out of c
1
and into c
2
.
This is true for both lenders and borrowers.
On the other hand, wealth effect will differ
between lenders and borrowers.
47
Notice that the effect of an increase in the
interest rate depends on how wealth is
measured:
Wealth measured in present value declines:
W= y
1
+ y
2
/R +
Wealth measured in future value rises:
W= Ry
1
+ y
2
|
48
When R rises, the value of current output
rises with respect to the value of future
output.
Lenders benefit, since they are wellendowed
with current output: For lenders, wealth is
increasing with the interest rate.
Borrowers suffer, since they are not well
endowed with current output: For borrowers,
wealth is decreasing with the interest rate.
49
For lenders (c
1
< y
1
):
Substitution effect: As R increases, current
consumption becomes relatively more
expensive c
1
goes down and c
2
goes up.
Wealth effect: As R increases, wealth
increases Both c
1
and c
2
goes up.
Hence, c
2
D
goes up and c
1
D
might go up or
down.
50
51
For borrowers (c
1
> y
1
):
Substitution effect: As R increases, current
consumption becomes relatively more
expensive c
1
goes down and c
2
goes up.
Wealth effect: As R increases, wealth
decreases Both c
1
and c
2
goes down.
Hence, c
1
D
goes down whereas c
2
D
might
go up or down.
52
53
Notice that for borrowers, since c
1
D
goes
down, savings definitely increases.
On the other hand, for lenders, since c
1
D
might go up or down, savings can decrease
or increase.
54
4. Borrowing Constraints
In real life, countries or households may
face borrowing constraint:
A limit on borrowing imposed by lenders
despite the ability to repay the debt.
Often, creditors are only willing to use as
collateral some fraction u, u e [0, 1] of future
income.
Depends on perceived riskiness of the
borrower.
55
So, even though a household can repay up to
y
2
/R tomorrow, it may only be able to borrow
uy
2
/R.
Reason for borrowing constraints: Lack of
commitment.
1. Households can declare bankruptcy
government regulation causing market
imperfection.
2. International borrowers (countries) can default
on their loans.
56
So:
1. What is the effect of a borrowing
constraint?
2. What is the effect of a country defaulting
on its debt?
3. Why is reputation important?
57
58
The incentive to default can be seen in the
figure.
Consider a small open economy that can
attain point A by borrowing.
This is the optimal point if our economy
pays its debt in the second period.
59
However, if our economy surprises
creditors by defaulting on its debt, it ends
up at point C, instead of point A.
But can they get away with it? Probably
not.
They need to protect their reputation so
that they can continue to borrow in the
future.
60
For a small country like New Zealand, the
real interest rate on the world bond market
is exogenous.
Nevertheless, real interest rate is a market
price determined endogenously by demand
and supply on world bond market.
61
5. Determination of Real Interest
Rate
What determines R on the world market?
Lets look at all countries in the world
together as being one large closed
economy (lets call it "world economy").
The world cant trade with others (unless
you believe in aliens)
62
Since world can not have a trade balance
surplus or deficit (X M = 0), world savings
s = 0.
Therefore, c
1
= y
1
, c
2
= y
2
.
Countries view R
*
as exogenous. But R
*
in
general equilibrium is consistent with s
*
= 0.
63
64
If all countries are identical, it must be that
no country trades, and so s
D
= 0 for
everyone.
Because households behave optimally,
slope of the IBC = slope of indifference
curve:
R
*
= MRS.
65
Let MRS = c
2
/(|c
1
) where |e(0,1) is an
impatience parameter.
Because all countries are the same (no trade),
it must be that:
Real interest rate is determined in part by
preferences (|) and in part by the expected
growth rate of the world economy (y
2
/ y
1
).
66
If shocks to countries productivity are
correlated, it is possible all countries get a
negative transitory shock (Ay
1
< 0, Ay
2
= 0).
What happens in the world as a result?
67
WorldRecession
First, GDP today drops (A C).
If real interest rate does not change, IBC shifts
in parallel fashion (we end up in B).
68
69
But if all countries come to point B, that
means they all want to borrow.
This is impossible: if all countries borrow
imported goods, there is noone to lend.
The competition for loanable funds must
drive real interest rate higher: General
equilibrium is restored at point C.
70
6. Summary
Consumption today determines consumption
tomorrow due to savings it is an
intertemporal decision. Our savings determines
how consumption is allocated over time.
Financial markets allow small open economies
to borrow and lend, so they dont have to
consume their GDP every period they can
smooth their consumption over time.
71
Consumption at any period depends on
lifetime wealth.
Therefore impact of income shocks depends
on whether they are permanent or
temporary.
Trade balance is related to savings but says
nothing about welfare of households.
Real interest rate is an intertemporal price
and reflects structure of the economy
(preferences and technology).
72
TermStructureofInterestRates
Imagine you are buying a house, and need to
finance it (for 10 years).
You have two options:
1. Longterm 10 year mortgage (term to maturity =
10 Y).
2. Shortterm 1 year mortgage (term to maturity = 1
Y) renewed 10 times.
The interest rates on these two mortgages
differ why?
73
Extend our model into 3 period: (y
1
, y
2
, y
3
),
y
2
= current forecast of GDP in medium
term, y
3
= current forecast of GDP in long
term. Then,
These are interests rates you would use to
refinance shortterm mortgage.
74
No arbitrage condition: Borrowing today
should cost the same amount if done
through shortterm or longterm mortgage
(with no risk):
R
*
13
is total interest you pay on longterm
mortgage.
75
The annual longterm rate you would have
to pay is just the geometric average of R
*
13
:
Longrun annual interest rate you would
pay depends on longrun GDP growth
forecast, not the mediumrun.
76
A pair of interest rates {R
*
12
, R
*
L
} is called
the term structure of interest rates, or yield
curve.
R
*
L
is the longrun and R
*
12
is the shortrun
interest rate.
Yield curve is a graph that plots these
interest rates on y-axis and termto
maturity on x-axis. (R
*
L
R
*
12
) is called the
slope of the yield curve.
77